Taming fiscal deficit key to India story: Moody’s

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India’s high fiscal deficit has exposed the economy to shocks and constrained the Baa3 sovereign rating with stable outlook, global credit rating agency Moody’s said on Thursday, warning that the July budget needed tough measures to restore macroeconomic stability.

Both prime minister Narendra Modi and finance minister Arun Jaitley have already hinted at a tough budget to put the slowing economy back on track.

Moody’s Investors Service said the Indian government’s budget deficit, which is higher than those in most similarly rated countries, increases macroeconomic imbalances and thus exposes the economy to shocks.

Moody’s report titled, “Frequently Asked Questions on India’s Fiscal Position and the Forthcoming Budget” released in New York outlines the reasons behind India’s high fiscal deficit.

The agency said that whether the new government’s 2014-15 fiscal deficit estimate is above or below the previous UPA government’s estimate of 4.1 per cent of GDP is not the key determinant of India’s credit outlook.

According to Moody’s, more relevant to the sovereign credit outlook will be whether the new NDA government’s budget in the second week of July includes measures that address the government’s low revenue base, high current expenditures, and exposure to commodity prices.

Nonetheless, large fiscal deficits raise the portion of domestic savings the government absorbs in order to maintain its favourable debt structure. This hurts growth by limiting the private sector’s access to those savings for investment.

In Moody’s view, in the absence of measures to reduce the fiscal deficit, the future high growth rates many forecast for India may not be realised. The July budget could indicate whether fiscal constraints on India’s sovereign credit profile would ease over the coming years

India has clocked sub-5 per cent growth in the last two years and many economists and analysts have indicated that it might take at least two-three years for the economy to return to the high 8 per cent growth path.

India, which registered average 8 per cent plus growth since 2004-12, has witnessed stagflationary conditions with slowing growth and high inflation due to global recession and several domestic factors, including policy paralysis that led to poor investor confidence.

Moody’s also provides a comparison between recent fiscal developments in India and in other similarly rated countries. The report explains how fiscal policy has affected growth, balance of payments and exchange rate trends and addresses the possible credit implications of the newly-elected government’s forthcoming budget.

India’s high budget deficits are partly due to a large population and low per capita income levels. Low income levels limit the government’s tax revenue base and at the same time drive socio-political pressure to increase government spending on subsidies and economic development. However, Moody’s notes that other countries with low per capita incomes have avoided deficits as large as India’s. This suggests that fiscal discipline can improve budget outcomes despite structural challenges.

The report notes that wide budget deficits have kept India’s inflation high and contributed to a widening current account deficit between 2011 and 2013, which heightened exchange rate volatility and resulted in higher domestic interest rates. These trends have exacerbated the slowdown in GDP growth since 2011.

However, the sovereign credit impact of high fiscal deficits was mitigated by the government’s favourable debt structure. Indian government debt is owed mostly in domestic currency, at relatively low fixed real rates, and at long tenors, which shields government debt service costs to some extent from currency and interest rate volatility.

These debt characteristics underpin the stable outlook on India’s Baa3 sovereign rating, it said.

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